Jackson Hole: The Fed’s message is clear — but the explanation isn’t

Federal Reserve Chairman Jerome Powell sent a clear message today in his Jackson Hole speech: The Federal Reserve is not contemplating raising interest rates any time soon even if it begins to taper its purchases of securities later this year.

The Fed can contemplate tapering because the economy has made progress in creating jobs. Powell noted that the Federal Open Market Committee (FOMC) will provide “advance notice” before tapering begins, and market participants now expect it will begin in November or December. But Powell does not believe tightening of monetary policy is warranted, because the recent spike in inflation is likely temporary and unemployment is still too high.

One of Powell’s objectives was to lessen the risk of a “taper tantrum,” or spike in bond yields. Eight years ago, the bond market sold off substantially when Fed Chair Ben Bernanke hinted that the Fed would phase down its bond purchases. The main reason was that investors interpreted the action as signaling a tightening of monetary policy, and the Fed had to repeatedly assert that “tapering is not tightening.”

Accordingly, Powell made it clear in his speech that the bar for raising interest rates is considerably higher than for tapering. He indicated that the Fed learned from prior experience that by raising interest rates prematurely it may have prevented the economy from reaching from its full potential. Also, he noted that if inflation was temporary, a hike in interest rates may not be felt for a year, by which time the problem may have disappeared.

Powell went on to elaborate the reasons why he and the FOMC believe the recent spike in inflation is temporary. They include the following considerations: (1) inflation pressures have not been broadly based; (2) prices of some items – notably lumber and used cars – have moderated; (3) wage growth has been moderate; (4) long-term inflation expectations are well anchored; and (5) inflation abroad is well contained.

What Powell did not discuss, however, was the role that monetary and fiscal policies play in contributing to inflation and inflation expectations. Earlier this year, in his Humphrey-Hawkins testimony, he dismissed the role that rapid growth in money supply may play. And in his Jackson Hole speech a year ago, he conceded that the Phillips curve relation between the unemployment rate and the rate of inflation was effectively flat.

In the meantime, the Fed has not put forth an analytic framework for assessing the long-run determinants of inflation. Instead, it appears to be operating in a vacuum, in which it explains inflation after the fact while asserting that isolated forces are at play.

In these circumstances, it is hard for investors to score how well the Fed is doing when it provides only vague guidance about what to expect. Thus, when Fed officials first enunciated their view that inflation was likely to be transitory, the impression was that readings might spike for several months due to base effects from inflation being abnormally low a year later. The latest readings, however, do not offer much comfort.

Friday’s report on the personal consumption expenditure (PCE) price index, for example, showed a 0.4 percent increase in July. It boosted the reading in the last 12 months to 4.2 percent, while the core PCE rose by 0.3 percent, lifting its year/year increase to 3.6 percent. 

Moreover, these inflation readings are not showing signs of easing: The 6-month annualized increases accelerated to 5.9 percent and 5.2 percent, respectively.

For the time being, investors have been willing to accept the Fed’s explanations at face value. Bond yields are well below levels reached earlier this year, while the stock market has gone on to post record highs.

One risk, however, is that investors’ expectations could shift quickly if inflation readings do not ease by year’s end. According to the Wall Street Journal, the Office of Management and Budget has doubled its forecast for CPI inflation to 4.8% in the fourth quarter from a year ago, and then sees it tapering off to 2.5 percent in 2022.

Meanwhile, investors will have a clearer understanding of the magnitude of federal spending that will be enacted for infrastructure and social programs and how they might impact the economy.

Another risk is that if the Fed falls behind the curve in tackling inflation, it will have to play catch up and boost interest rates by considerably more than it currently envisions. While Fed officials are quick to say they have the necessary tools to bring inflation under control, the open question is how willing they will be to deploy these tools if they threaten the recovery.

Nicholas Sargen, Ph.D., is an economic consultant and is affiliated with the University of Virginia’s Darden School of Business. He is the author of “Investing in the Trump Era; How Economic Policies Impact Financial Markets.”